From SoCal Real Estate’s December 2018 issue:
SoCal investor strategy for 2019
By Carrie Rossenfeld
Investing in Southern California commercial real estate is not for the faint of heart or the naïve. Investors have a broad and deep pool of competitors, both domestic and international, who are willing to pay top dollar to own a SoCal property, so they really need to be clear about their strategy when bidding on an asset.
SoCal Real Estate sat down with Val Achtemeier, EVP of CBRE Capital Markets in the Debt & Structured Finance Group in Los Angeles, to discuss how “bridesmaids,” who didn’t win the deal in the past, are preparing to ensure their future success, how investors are approaching the SoCal market amd their strategies for 2019.
SoCal Real Estate: What is the mindset of a “bridesmaid” investor, and how does this type of approach impact future transactions?
Achtemeier: There’s been so much liquidity coming into U.S. real estate for years. More investors of all stripes are targeting a larger percentage of their allocation to real estate, which speaks well for the asset class.
This also makes for many more of what I like to call “bridesmaids”: those who bid on a deal or deals, were unsuccessful, and did not win so they are more determined than ever to win the next one. Like any other competitive situation, if you have a stated strategy and a goal to place equity in real estate transactions and have a paradigm of the type of deal you are seeking, you are following a very sophisticated management process right now.
Most investment sales deals are openly marketed, so usually investors submit an offer and go through several rounds of bids. If you get into the best and final round — which used to be one or two, but now is often up to five — it gets extremely competitive. You may not be able to go to the next level for some reason: timing of closing, pricing, due diligence, financing, etc. And if you didn’t ultimately get awarded the deal, psychologically you want to figure out what you can to do win next time.
There are a lot of competitive forces right now. Generally, there’s more liquidity than there are attractive deals to buy. For a lot of these deals, investors will spend a lot of time and focus in multiple rounds. If you’re one of the bridesmaids, you tend to huddle internally and ask, “What do we need to do differently: step up sooner on price? Waive contingencies sooner? Adjust our return target so we push more on price?” If you end up being a bridesmaid too many times, you figure out what changes you need to make to win. In the end, you must satisfy the needs of your investors and place capital.
If you were in the hunt on several transactions but didn’t ultimately win, sometimes you will change your criteria regarding deal size, pricing, or leverage, or you will take the market feedback and go back to your investment committees. For the bridesmaids, it’s like going for the national title in a sports competition.
You’ve told us you believe we will be seeing more large transactions and even portfolio transactions in SoCal in the coming months. What factors are leading to these sizable transactions?
Scale in general is very desirable right now for capital both on the debt and equity side. It adds to efficiency and diversity. So, from a resource perspective, for many investors it is often desirable to do larger deals.
We’re also seeing more global capital — which tends to play in the larger size range — attracted to California. It’s been an excellent market with strong fundamentals and solid expansion here, especially in industrial. We will be seeing many large, national industrial portfolio deals in Q4 and Q1 2019 as it is becoming more desirable to do large deals, including platform transactions. Scale is desirable, and there’s a pricing premium for it.
How do individual transactions fit into investors’ overall strategies regarding certain markets?
Investors are very savvy, and if they want to establish a presence in a market or submarket but not yet know the market players, then they have to compete hard to win. For example, sometimes people coming from the East Coast don’t have relationships on the West Coast, but they want to be taken seriously. So, they may stretch out to win a few deals in order to be seen as a viable competitor. They’ll start to spend more time here, build relationships, and be taken seriously when they make offers. (Sellers want to make sure when buyers make offers that the offers are actionable.)
Investors might go slightly off target from their typical deal in order to get established in a market. Yields are tight across all markets, and investors may access different buckets of funds. A core fund might take on more risk, and sometimes even a value-add fund can take on more core-plus properties because the investor will do more renovation or redevelopment. They may also go outside their comfort zone geographically just to get dollars; an investor who has traditionally invested in Los Angeles County might go down to Carlsbad or out to the Inland Empire East to get more yield. Investors are constantly looking at geography in order to execute on their strategy; they might modify their geographic and property profiles to get more dollars invested or will take on more leasing risk because core asset yield is so compressed. They’re adjusting their strategy and return targets based on where they can place money and relative value of other investment options.
Are investors willing to take a loss just to get into the SoCal region?
I don’t think they would take a loss, but they might take an adjusted forecasted return. They might come in and buy land to do development in order to get a flag in the market. But there’s a limit. Sometimes we will see a public company like a REIT changing its strategy, doing more of a different property type or a new geographic focus and stretching more. And they may take an adjusted return if it’s a strategic acquisition to accomplish their long-term goals.
What are investors’ chief concerns now when considering SoCal deals?
It varies by property type. If you’re talking multifamily, the concern would be the amount of supply we’ve had come online in areas like Downtown, Los Angeles. Labor is becoming a big issue across all property types. If you look at the labor-participation rate, recruiting and keeping talent is a big issue in the office and logistics sectors. It’s not an insurmountable concern necessarily, but you want to be comfortable that a property type will sustain its favorable fundamentals. The cost of doing business here is a concern from a tax perspective and overall cost of living/operating expenses. You want to make sure tenants are able to be profitable since they have a pretty big tax burden to do business here. Of course, the positives outweigh the negatives in SoCal. We have a large, diverse population base and NOI/rent growth is a driving factor.
What else should our readers know about this topic?
People are so happy when they’re awarded the deal. Even on the debt side, it may be an inefficient market, but they’re still happy when they win on deals. Liquidity drives a lot of competition, and there’s a real art to determining the maximum economics for the seller and/or borrower. It creates an interesting dynamic in the market. I feel robust liquidity will stay for a long time. Everything has cycles, but the strong liquidity appears very sustainable.
SIDEBAR: How are retail investors’ strategies changing in the SoCal market?
SoCal Real Estate recently interviewed Philip Voorhees, EVP of CBRE in its Newport Beach, California, office. (See the feature “Deal Masters” in our November issue.) In addition to discussing what it takes to be a retail CRE superstar in Southern California, Voorhees also told us about some of the strategies retail investors are using to get ahead in the SoCal market.
In times of change, a flight to quality ensues, Voorhees says. “Presently, no investors are selling the highest quality ‘core’ retail assets because they cannot be replaced, yet nearly all institutional investors want to buy core retail product.”
Without much of a development cycle manufacturing core retail product, and with great investor interest in owning retail in the west, Voorhees says you could describe the result as “core constipation”: not much core retail is moving in the west. “Just off core, often described as ‘core plus,’ institutional investor demand falls off sharply. This creates opportunity for investors using leverage.”
For example, he says, buying at a 6.5 percent cap rate, when the US 10-Year Treasury Yield is at +/-3.0 percent provides 300 basis points of spread for positive leverage, a wide margin historically. “The opportunity to take a significant portion of the total return expected from cash flow is compelling compared with lower yields in the bond markets.”
With record-low unemployment and real wage growth approaching 3 percent, consumer sentiment will likely continue improving,” Voorhees says. “Retail fundamentals presently feel quite strong. We expect surging investor interest in retail over the next 12 to 18 months. Pricing has little room to improve, but transaction volumes should increase.”